Tuesday, March 4, 2014

Russia and the global deflation threat

Stocks came under selling pressure on Monday in the wake of renewed concerns over geopolitical instability in Eastern Europe.  An escalation of tension between Russia and the Ukraine led to a plunge in Russia’s stock market, which in turn had a spillover effect on U.S. equities….

Russia is currently the focus of Wall Street’s worries right now.  One of the better proxies for Russia’s stock market is the Market Vectors Russia ETF Trust (RSX), which lost nearly 7% in value on Monday.  RSX made a 4-year low today which underscores the political and economic troubles facing that region of the globe.  I’ll have more to say on Russia and its ally China later in tonight’s report….

Aside from the potential spillover impact of Russia’s stock market decline, an even bigger concern as we head into spring is China’s stock market.  The iShares China Large Cap ETF (FXI), our favorite China proxy, is struggling to get back above its 15-day moving average.  It’s also dangerously close to its recent low from early February.  A violation of the February low would almost certainly touch off another wave of investor concern over China’s economic outlook and would most likely be used as an excuse to sell U.S. equities (as was the case in January).  There has been an historical correlation between FXI and the S&P in recent years, with China stock weakness leading to U.S. market weakness more often than not….

Russia’s crashing stock market is in many ways similar to the tumultuous events of the summer of 1998, which witnessed an outbreak of deflationary pressure in commodities.  It began early that year with weakness in Asian economies and was accelerated by the Russian ruble crisis.  By the summer of ’98 those troubles were brought to bear on the U.S. financial market.  In only a matter of weeks, a record high in the Dow was transformed into the shortest bear market on record – a 22% plunge in the S&P over a period of just a few weeks.  Of course the bear market bottomed in October and by year’s end the major U.S. indices were heading back toward their old highs.  But the lesson learned in that event is that deflation-driven bear markets can occur swiftly and suddenly, even when everything looks rosy.  Keep in mind also that the U.S. economy was experiencing a powerful bull market in its own right at that time, which reminds us that the state of the economy can’t be used as a leading indicator when it comes to the stock market.

The 1998 experience, and more recently the Russian crisis, also reminds us how swiftly deflationary undercurrents in the global economy can lead to major trouble.  It pays to keep on your toes during the final year of the long-term deflationary cycle, and stock picking and market timing are absolutely essential.  A good money management strategy (i.e. a stop-loss discipline) is also a must in the event of a rapid reversal of trend. 

[Excerpted from the Mar. 3 issue of MomentumStrategies Report.]